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Signs of market stabilization… for now…

2016 has started off with severe volatility in the financial markets.   The downturn in Chinese equities has led to global contagion as the Shanghai Composite had two trading days end closed 7% limit down and forced Chinese financial regulators to dispose of their circuit breaker policy.  Additionally, the S&P has experienced the worst calendar year start ever.  With so much uncertainty about future market direction, GFC would like to highlight some interesting market divergences that may point to signs of stabilization over the short term.

Last week saw a dramatic intraday reversal on Wednesday with Dow Jones Industiral  Average losing 538 points intraday.  During the midst of the selloff, the advance/decline ratio registered .0333 meaning that there were 30 stocks down for every 1 up.  However, by the end of the day, the market recover to only lose about 250 points with an A/D ratio of .40 meaning there were only 2.5 stocks down for every 1 up.  It was quite an intraday shift in momentum as many stocks experienced significant intraday reversals.  The rest of a the week continued bullish with the market forming a fairly compelling reversal on the weekly candle.   (see chart below)

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The market reached very oversold levels last week and was due for a short term rebound.  Whether or not this bounce has legs remains to be seen.  GFC is of the belief that additional downside risk at this time is significant, and advise that speculators sell into strength should it manifest.   The Daily Moving averages are confirming that a bear trend is in motion as the market is trading below the 50 DMA which is currently trending below the 200 DMA.  Should the market rally to the 1925-1950 area GFC is prepared to enter into short positions.25JAN16-2

Another interesting divergence that we noticed last week was that the VIX was not registering the type of volatility normally present during a panic.  Despite rather severe selling pressure which carved out lower lows in the markets, the VIX was unable to eclipse the high it made during last summer’s selloff when it peaked on August 24th.  This was a warning sign that the market was likely to stabilize in the short term which it did.    (See chart below)25JAN16-3

Another interesting and most unusual divergence that has been occurring lately is that of the performance of the U.S. Dollar in the Spot FX markets compared to the performance of U.S. treasury bonds.  This divergence has been occurring since early December when the dollar shorts covered their positions on December 3rd.  Since that time the EURUSD pair, the largest (47% weighting) component of the U.S. dollar Index, has generally been trading with a 150 pip range of the 1.09 level.  GFC finds this interesting because while global equity markets have been selling off, the U.S. bond market has experienced a significant flight to safety bid.  On December 3rd, the 10-year U.S. Treasury bond was trading with a yield of 2.33%.  Over  the past 2 months, yields have declined to  2% even where they are trading today.  Normally when the bond market receives a safety bid like this, so does the US dollar in the FX markets.  However this has not happened.  The dollar has failed to rally against other major currencies.  What makes this even more intriguing is that last week the ECB President Mario Draghi alluded to the possibility of additional QE measure for the Eurozone.  GFC is surprised the US dollar didn’t have more of an FX rally than in did in the wake of this news which signaled a major diverging between U.S. and EU monetary policy.

Usually the bond market leads and other asset classes follow, so if the smart money is right, we should soon see the U.S. dollar begin to rally substantially in the FX markets.  A closing above 100 on a weekly basis for the USDX will signal further dollar strength lies immediately ahead.    Additionally, a closing below 1.0710 on a daily basis in EURUSD will signal additional weakness for the pair.

In review: The Big Short

The New York Times Best Seller “The Big Short: Inside the Doomsday Machine” by Michael Lewis hit theaters last month with much anticipation and populist acclaim from Hollywood.  GFC would like to provide a subjective review of the film for our readers who, have most likely either read the book or, are at least intimately familiar with the storyline of the financial crisis of 2008.

Let us start by saying this is easily the best financial film since Margin Call starring Kevin Spacey debuted in 2011. (For those of you wondering where Wolf of Wall Street ranks in our hierarchy of financial flicks, just know we regard that movie as a sad and debauched production with very little substantive content to qualify itself as a legitimate Wall Street Classic)  With that being said, The Big Short is a very captivating story which  provides great insight to the real stories of the people who not only saw the crisis coming, but had the wisdom and the fortitude to bet against the U.S. housing market and profit handsomely by doing so.

The story primarily revolves around 3 people, Greg Lippmann, a CDO trader at Deutsche Bank who was intimately familiar with the toxic mortgage backed securities his desk was packaging and selling, Steve Eisman, a outspoken hedge fund manager, around Dr. Michael Burry, a former neurology specialist turned Portfolio Manager at Scion Investments Inc.  The story tracks how these people were among the first to recognized serious trouble on the horizon and details their creative and heroic trading exploits as they were able to capitalize on the greatest financial crisis since the Great Depression.

For the average American, who is still grappling with understanding how the housing crisis nearly bankrupted the entire U.S. financial system, The Big Short should be required viewing in order to gain a basic understanding.  The movie does a great job explaining the origin and evolution of complex financial instruments such as Mortgage Backed Securities (MBS) Collateralized Debt Obligations (CDO) and Credit Default Swaps (CDS).  The movie dumbs these concepts down as much as possible and even provided cameo roles to random celebrities who explained these synthetic financial instruments with creative abstractions in order to hold the attention of the financially illiterate.

Despite showcasing an all-star Hollywood cast consisting of Brad Pitt, Ryan Gosling Christian Bale, and Steve Carrell, the true populist attraction of this film emanates from America’s feelings of antipathy towards Wall Street bankers in the wake of the financial crisis.  It’s easy to envision many young females buying tickets to this movie because of the Hollywood heartthrob cast, and then watching the screen as the entire plot flies over their head.  Only an intellectual audience is fully capable of appreciating this movie.

As a financial professional, one of the key takeaways for me was recognizing how complex the trades these guys were putting on actually were.  It’s important to know that up until 2005, the market for mortgage backed securities was a one way market.  Long only.  Dr. Michael Burry had learned about the fledging credit default swap market and literally had to petition the big banks to allow him to buy credit default swaps on specific mortgage bonds he knew were likely to default.  They reluctantly agreed to create a new CDS market for him and at first were happy to sell him default insurance and initially charged him basis point premiums which were essentially the cost equivalent of insuring AAA rated bonds.   He was one smart cookie to not only recognize that the MBS market was going to fail spectacularly, but he got into the trade so early, that the banks were willing to make an entirely new CDS market for shorting subprime mortgage bonds, which they only agreed to because in their minds he was buying insurance for the end of the world.

Another aspect of the storyline that could have been emphasized a bit more, was that after throughout 2006 and 2007 as adjustable rate mortgages were being reset higher and mortgage delinquencies began to rise dramatically, the banks were not properly adjusting the value of the speculative positions in their CDS markets.  Consequently, people like Michael Burry and Steve Eisman were being forced to pay additional insurance premiums on their CDS positions because the banks were not marking the value of their MBS bonds to market. The large Wall Street banks had assigned artificially high values that their optimistic MBS pricing models were projecting irregardless of the actual economic performance of those bonds.  The movie could have done a better job highlighting the key importance as well as the key legal battles that were waged over the importance of mark-to-market accounting during and after the crisis.  Nevertheless, the movie revealed how the tension stemming from bank reluctancy to mark down the value of their CDO & MBS securities directly led to undue financial stress for the people who got it right and correctly bet against such instruments.  One can only imagine the agony of being 110% correct and having to fork over another monthly CDS insurance premium in the tens of millions of dollars each month, knowing #1) that the banks are defrauding you, #2) that you have to pacify investors who are going to wonder why your fund experienced another monthly drawdown, #3) that you have been 110% correct on the crisis and are losing money. Personal Note: During the Crisis, I was short many different banks stocks until the SEC banned the shorting of financial equities on Sept 19th 2008. On that day there was a massive artificially induced short covering rally with the  Dow Futures up over 600pts before the markets opened and I was subsequently forced to cover my positions at steep loss despite being 100% right about the solvency of the U.S. banking system.  My account was relatively small at the time as I was fresh out of college and only 22, however, the disgust and loathing the hedgefund managers in the film must have felt toward the big banks when they literally billions of dollars in the game can only be imagined.  

The final takeaway from this film that needs to be addressed fully is Hollywood’s exploitative demonization of Wall Street as well as the subtle narrative of class warfare this movie promotes.  Michael Lewis’s book was a great expose into how a small group of men who thought outside the box were able to identify and profit from a speculative mania. The main intention of the book was not to be a damning indictment of  banker corruption that contributed to the crisis, and even if it were, corruption within the banking system itself would be wholly inadequate.   Unfortunately for America, Wall Street, and audiences everywhere, the main takeaway from the The Big Short is a theme of banker corruption.

 

SPOILER ALERT:  The last scene of the movie offers a satirical ending with bankers being walked away in handcuffs as the narrator says:  “In the years that followed, 100’s of bankers and rating’s agency executives went to jail. The SEC was completely overhauled.  And Congress had no choice but to break up the big banks and regulate the mortgage and derivatives industries.  Just Kidding.”  For anyone who wasn’t asleep under a rock during and after the financial crisis, you know that’s not how the story ended at all, and therefore these satirical statements are more than a stupid joke, they are subtle exploitation of ignorance directed toward the type of people who know how their fantasy football team performed but couldn’t tell you what a bond is.  The satirical ending is meant to influence ignorant people into believing that banks going to jail is what should have happened and there is a deep wrong that injustice has been served Basically, the end of movie could instantly be transmuted into a Bernie Sanders class-warfare campaign video.   Deeper contemplation is needed to truly understand how the crisis happened.  The Big Short ultimately comes up drastically short of offering a comprehensive explanation of how and why the financial crisis occurred.

Prudent observers should ask themselves: “Why weren’t Wall Street bankers greedy and corrupt before the mid 2000s?  Why did the financial crisis happen when it did?   Mortgage Backed Securities have been around since the 1970s, why did it all blow up in 2008?”   To answer those questions one has to understand that the actions of bankers is largely dictated by monetary and regulatory incentives emanating from the Federal Reserve Bank, the U.S. Treasury, and Congress.  President Bill Clinton signing legislation which repealed the 1933 Glass-Steagal banking regulations was left out of the film entirely.  Additionally, a historical recap of the Federal Reserve’s interest rate policy decisions made by Alan Greenspan which lowered interest rates to 1% and incentivized loose lending practices by bankers after the dot-com bubble was conveniently omitted.  Also completely omitted were the roles played by Federal agencies such as Fannie Mae, Freddie Mac, and the Department of Housing and Urban Development (HUD) in which not only originated vast quantities of shitty mortgages but guaranteed them with a subtle tax-payer guarantee which eventually occurred to the tune of more than a trillion tax-payer dollars.

Was there fraud committed by bankers on Wall Street leading up to the financial crisis?  Undoubtedly there was, but it pales in comparison when compared to asinine legislative policy decisions propagated by the Federal government itself.  Ultimately the elected representatives of the American people voted to bail out the bankers with Secretary of the Treasury Hank Paulson and the Chairman of the Federal Reserve System Ben Bernanke imploring congress to bailout the financial system.  The satirical ending of this film insultingly assumes the American populous is just as dumb and ignorant after the crisis as there were before.    With all that being said, it worth remembering that Hollywood’s true motive is to sell movie tickets and entertain, not truly educate people.

Overall Rating: 5.5/10

Dollar Currently at Significant Inflection Point

GFC wanted to post this update on the U.S. Dollar to alert our readers on a high probability trading opportunity.  Last week the dollar rallied on light volume through the holiday week to approach the previous 2015 high at 100.39.   This has many dollar bulls excited, however optimistic sentiment toward the buck seems to have reached an extreme with so many analysts expecting the dollar to continue to rally and achieve new highs for the year.

The current technical picture is sending strong caution signals to the bulls.  The first major factor the bulls must consider is the strong overhead resistance that prices are now confronting.  The high of the year which was achieve on March 13th, has not been tested since.   In March the dollar encountered substantial selling pressure as a year-long rally came to an abrupt end just above the 100 level.  Additionally, recent price action in November has seem diminishing returns in terms of both bullish momentum and price action.   While the US Dollar has been able to achieve a series of higher highs and higher lows this month and keep the bullish trend intact, it has done so at the expense of momentum as price action as devolved into a much slower-upward grind without much conviction.

Finally, during the recent rally of the past 5 weeks, the US Dollar has charted out a well defined internal trend line which initially acted as resistance and is now acting as support.  The dollar reacted to this line on 8 separate daily occasions, and therefore this trend line should be considered very important.  The current technical picture of the U.S. Dollar Index is provided below.

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GFC believes that because of the tentative overlapping price action leading into a major area at 100.39, combined with waning price momentum, and a strong possibility of a break of a significant support trend line, the timing this week looks very ripe for a pullback in the US Dollar.  To take advantage of this pullback, it is helpful to look at the EURUSD currency pair which comprises 47% of the US. Dollar Index.

Not surprisingly, we can a similar set up for the Dollar against the Euro.  The euro looks like it has imminent potential to rally against the dollar which means dollar weakness.

29NOV15-2

The Euro, opposite to the dollar is sporting a very nice downward sloping resistance trend line, while also experiencing a loss of downward price momentum.  Reflecting the dollar, the euro has approached a significant support area that seems likely to hold, at least temporarily.  If/when the Euro is able to break this trend line, it will at the very least signal a short term change in trend to alleviate the oversold condition.

 

Geopolitical market update

Perhaps the most interesting aspect of the market action over the last two months has been the persistent resilience of the stock market as it has largely recovered from the fearful expectations that were present in late August.  If you remember, the morning of August 24th saw the Dow Jones Industrial Average open down more than 1,000 pts before recovering intraday.  Immediately afterwards, many analysts were predicting the market would make lower lows.  In the 2 months since the panic climaxed on August 24th, we can looked back and see the market has stabilized.

Just because the market has stabilized, doesn’t mean that the risks that were present in late summer no longer exist.  China is still mired in a substantial economic slowdown.  The Federal Reserve’s Keynesian monetary policy has Janet Yellen and the FOMC boxed into a corner.  Similarly, Congress game of playing “kick the can” with the national debt ceiling is looking more and more like “kick the grenade.”  The Eurozone remains a complete disaster with deflation strengthening its grip as the continent braces for the cultural and economic impact of the largest migrant crisis to hit Europe in hundreds of years.

These geopolitical developments are real risks to the global economy and are likely to persist in the years ahead.  Sovereign governments around the world, because of their general irresponsibility and fiscal mismanagement, are facing massive liabilities and potential insolvency.  The depressed price of oil is going to exacerbate an already volatile political climate in the Middle East.  With all these major geopolitical risks combining to create an almost perfect storm of economic turbulence, it is important to consider the U.S. dollar as the asset most likely to outperform well during a possible season of crisis. The dollar remains the reserve currency of the word has recently signaled that it is ready to resume it’s advance relative to other global currencies.

GFC_OCT1

Since March of this past year, the dollar has been in a major sideways consolidation pattern.  The specific type of pattern where price has a significant rally and then goes sideways is called a “Flag-Pattern” or in this case a “Bullish-Penant” and it is a common type of continuation pattern.  We at GFC expect the dollar to rally in the months ahead and to ultimately climb to new highs as the U.S. dollar is likely to benefit from its perceived safe-haven status.  With all the current geopolitical risks still in need of reaching a point of resolution, the dollar is likely be the main benefactor of international capital flows in 2016 and beyond.

Fed’s rate decision impact

This past week saw increased volatility as the Federal Reserve predictively decided to maintain interest rates at zero percent.  It was the 55th consecutive time that the Federal Open Market Committee met and agreed that the cost of money lent to banks should be free.   This unprecedented period of easy monetary policy by the Federal Reserve is a sad commentary on the health of the U.S. economy.  GFC forecasted the FOMC’s rate decision 5 days in advance via our new Twitter Feed!  GFC invites you to follow us on Twitter for important market tweets and commentary.   https://twitter.com/GeoFrontCapital

Inside the FOMC’s released statement they explained their rational for leaving interest rates unchanged, citing global economic instability, recent market volatility related to China’s contraction, and inflation levels below their preferred target of 2%.   The only dissenting Fed vote came from Richmond Fed President Jeffrey Lacker who voted for a rate hike of 25 basis points.   The near unanimous decision reflects just how worried the Fed is about a potential negative market reaction. We at GFC suspect the Fed is also concerned about the prospect of a strengthening U.S. dollar which would serve to exacerbate foreign capital flows coming out of Europe and into the U.S.   The goal of successfully deflecting foreign capital flows into the U.S. dollar is conceivably the Fed’s #1 goal at this time. Rising interest rates would likely strengthen the dollar, make it harder for debtors to fulfill their financial obligations, and therefore contribute to an increase in domestic deflation.

As our readers are aware, GFC has maintained a bullish stance on oil for the last 3 weeks since it broke out above its downward sloping trendline.   After spiking about 30% from the low, oil traced out a triangular consolidation pattern.    Triangles are typically continuation patterns, meaning they break out in the direction of the prior trend which, immediately before this triangle formed, was up.   As you can see in the oil chart below, oil broke topside out of the triangle on Wednesday and climbed to $47.69 before reversing. Often times when prices break out of important trendlines, they often revert back to the trendline to test the breakout’s validity.

fed_rate_decision_Sept2015

Oil sold off after the FOMC rate decision and retested the trendline by forming an intraday low at $44.22, which is the precise location of the former triangle resistance line, which is now support.   The support boundary of the triangle created a lot of support in the $43-45 range and this most recent low appears to be an ideal place for oil to continue rising toward $50 a barrel.  If oil is able to close below $43.50, then our bullish interpretation would be invalidated.

Another commodity that GFC has a bullish outlook on is gold.  We believe gold made an important bottom on July 20th at $1,071 an ounce.  From this low, gold rallied almost $100 to $1,170.  Over the past 3 weeks gold retraced about 2/3rds of this $100 rally and made as late last week resumed it’s climb upward from $1,099.  Gold seems to like the Fed’s decision to keep the cheap money flowing as it climbed more than $25 in the wake of the FOMC’s rate decision.   In the 4hr Chart you can see that Gold traced out an impulsive  5-wave Elliott sequence and is then declined in 3 waves into the $1,099 low.   GFC believes gold is in a 3rd wave which is the most powerful wave and should draw gold significantly higher to over $1225.


fed_rate_decision_Sept2015-4

Additionally, Gold created a bullish engulfing candle on the weekly chart and also of importance is the fact that MACD closed the week positive.   Considering the wave structure and the prospect of a delayed Fed Rate hike into the foreseeable future, the prospects for gold to rise in the weeks ahead look promising.  Near-term, gold may experience a slight retracement early next week, but GFC expects gold to climb much higher over the intermediate term.

fed_rate_decision_Sept2015-2

The most volatile response to the Fed’s rate decision arguably occurred in the FX markets.  The dollar initially sold off as expected immediately following the news.  However, today the dollar rallied ferociously and looks poised to continue its surge.   The Euro makes up over 47% of the US Dollar Index which is comprised of a basket of global currencies.  Because it accounts for such a large share of the weighting within the index, it is often referenced as a reliable proxy for where the dollar is headed next.

fed_rate_decision_Sept2015-3

The EURUSD has been consolidating slightly upwards for the last 6 months ever since it made a low at 104.62 on March 13th.   The consolidation since then has been very ugly with no definable trend.  Last month EURUSD made a high of 117.13 and sharply reversed.  There is a potential that today’s price action signals the resumption of EURUSD’s imminent decline.   Ultimately, GFC is expecting the Euro to fall below parity with the dollar and potentially much lower.  If prices are able to close below the recent upward trendline it would signal that the next significant selloff in the EUR is underway.

NEWS UPDATE:  GFC will be offering paid subscription services providing weekly market commentary, insights, and analysis starting in January 2016.    For more information on how to subscribe click here.

Trend Reversal in Oil

This past week GFC published an article describing the possibility of a significant bottom in the oil market.  As it turns out, market observers didn’t have to wait long for the bullish price activity to commence.  From it’s low of $37.73, oil rallied 20% and closed the week at 45.27 after reaching an intraday high on Friday of 45.87.   Keep in mind that percentages always look larger when prices break away from smaller bases.  Nevertheless, we perceive oil’s recent rise to be of significant importance. A variety of technical indicators (MACD, RSI indicating bullish divergence, and the imminent break of a 2-month resistance line)  foreshadowed the most recent rise in oil and it has indeed been quite forceful. GFC forecasted the possibility of a significant increase in oil when we wrote:

“..if oil is able to solidly close above this recent 2-month trendline, it would signal an opportunity to enter into a long position and bet on a retracement rally which should be rather sizeable considerable the scope of the decline”  -GFC’s Update on Oil’s Decline 8/26/15

As the fate of the market would have it, oil proceeded to break this trendline during the very next trading day and the bulls haven’t looked back since.  Here is an update chart depicting oil’s break of the trendline.

OIl Reversal

MACD is now clearly indicating oil is in a bullish trend.  Furthermore, on this weekly chart below , you can see that this past week, oil made a new low when it bottomed at $37.72 and closed the week substantially higher at $45.27 which has formed a bullish candlestick pattern on the weekly chart.

Oil Reversal 2

The fact that this candlestick is forming after a 5 wave elliot-wave decline implies that oil has significant room to rally in the weeks ahead.   Ultimately, prices have the potential to retest the wave 4 highs in the $60 handle before the upward.  Oil speculators should now officially consider the new trading environment in oil to be amicably bullish and remain long this new trend until changing market conditions signal otherwise.  The rapid rise of the last two days represents massive levels of short-covering which has naturally occurred at what appears to be the exhaustion of a 2-year decline.  GFC will update our readers when we believe the overall bearish trend is likely to resume.

Update on Oil’s Decline

The Chinese economic slow-down is sending huge shock-waves throughout the investment landscape.  Commodities in general have been crushed as fears over decreased demand from China breathed new life into the downward trajectory of commodity prices.  The price of oil has been declining since August 28th, 2013, when it made a swing-high above $112 a barrel.  Today, after a declining period of almost 2-years, oil is trading below $39 per barrel after a total percentage decline of more than 65%.  GFC has already alluded to the devastating implications this price decline is going to have on the domestic shale-producers and fracking industry as the price of economic viability for their industry is between $60-70 a barrel.  Our research has also revealed that almost 20% of all corporate junk-bonds belong to the energy industry.   When these bonds come due, we are likely to see a wave of corporate defaults directly related to the prolonged and depressed price of oil.  However, against the recent backdrop of this historic oil decline, there are positive technical signs that oil is close to a bottom and a sizable bounce is very possible.

Looking at a recent daily chart of oil, you can see that on June 24th, oil’s decline began to embark on another leg lower which has been a sustained decline.   Furthermore, this decline over the past two months has formed a very valid trendline which has acted as resistance on 4 or 5 separate occasions.  Additionally, on the daily chart, the MACD (Moving Average Convergence Divergence) indicator is still indicating a bearish trend.  However, it is also very close to potentially turning to bullishness.  Additionally, if oil is able to solidly close above this recent 2-month trendline, it would signal an opportunity to enter into a long position and bet on a retracement rally which should be rather sizeable considerable the scope of the decline.

Aug 2015 Oil 1

 

Looking at oil on a weekly chart, we can see that oil has traced out a 5-wave decline from August of 2013.   Wave 5 is currently nearing its ending point.   The price of oil has been trading as though it is intent on testing the January 2009 low around $33 which was carved out during the financial crisis.  While we at GFC predict the price of oil to ultimately break though the 2009 low , however we  currently view the 2009 low price area as an attractive level for oil to stabilize and mount a retracement rally.   As you can see on the weekly chart, the RSI (Relative Strength Index) is indicating a bullish divergence as price declines into this area.  Oil prices are making new lows, but RSI is displaying a lack of momentum and is failing to confirm these new price lows.

Aug 2015 Oil 2

Additionally, GFC’s proprietary oil contango index is indicating selling capitulation among major oil investors.  For the past few months oil contango levels have remained at relatively high levels indicating institutional entities were keeping elevated amounts of oil stored in off-shore tankers and were hoping to unload it domestically at higher prices.  Currently GFC’s contango index is indicating oil is being moved to market and sold at current prices which should serve to drive oil to new lows in the near future.    With contango levels showing more moderation, it seems institutional investors continue to be cautious about future oil prices.  Stabilization in these levels and an increase in contango should indicate a more bullish outlook for oil prices; this has so far not materialized.  GFC is committed to monitoring the oil market and will be sure to alert our readers when trading conditions in oil turn amicably bullish.

 

Global economic update

The month of July saw a marked increase in volatility in financial markets as the growing specter of deflation continues to looms large over the global economy.  The month started off with yet another new debt rescue deal which essentially placed another Band-Aid on the sucking chest wound that is Greece and the untenable Eurozone debt situation.  July also saw a continuation of China’s equity market collapse, which has so far erased more the three trillion dollars in market capitalization from the Shanghai Composite index.  Asian investors luckily experienced a brief pause amid the panic selling mid-month as Chinese government efforts, combined with the People’s Bank of China (PBOC), were temporarily successful in stemming the avalanche of selling.  However, by the end of the month, China’s equity markets looks as though it has effectively resumed its decline as the Shanghai Composite closed down over 8% on Monday, July 27th as over 1600 stocks on that exchange traded locked limit (10%) down. Despite unprecedented levels of intervention exhibited by the Chinese government and the PBOC, equity prices continued to fall this week amidst a new torrent of selling.

Recent price action in Asia may offer a clues to potential market dynamics Western investors are likely to experience in the future. It is important to understand that China’s equity markets were indeed in bubble territory earlier this year as the their share-markets experience over a 150% ramp up in just the last two years as they retested the pre-financial crisis highs of 2007.  Technically speaking, the Chinese equity market looks like has experienced a classic “Blow-off top” after an exponential rise.  Blow-off tops usually revert back to where the advance started, which in the case of the Shanghai Composite is SIGNIFICANTLY lower.  Currently the U.S. stock market does not appear anywhere near as susceptible to a decline of the same magnitude as China. However the recent market behavior within Asia is already creating shockwaves that are reverberating throughout the financial system.

Perhaps the most under-reported aspect of the Chinese slowdown is the effect it is likely to have on the demand for oil.  China is the 2nd largest economy in the world and has been largely accountable for the majority of new energy demand in the 21st century as its economy has boomed.  The recent slowdown in China represents a major headwind for the price of oil.   Additionally, with all the forced liquidations occurring within the Chinese equity market, one has to wonder what other assets might the Chinese begin to sell in their mad dash to generate cash?

The most attractive resource that the Chinese have at their disposal with the ability to generate desperately needed cash, is the $1.3 trillion worth of U.S. Treasury bonds they collectively hold.  Reports have recently surfaced that the Chinese have begun to unwind their massive positions in U.S. fixed income market. This development combined with the existing low levels of liquidity in the U.S. bond market presents a dangerous combination that may lead to sharply lower bond prices later this year.  GFC imagines there aren’t going be a lot of investors willing to step in and place a bid against the prospect of the largest holder of U.S. treasuries unloading their positions on the open market.  Add in the fact that this scenario could develop simultaneously with the prospect of a Federal Reserve beginning to raise interest rates for the first time in 9 years later this fall and you have a strong recipe for a significant sell-off in bond prices.

With China’s bull market experiencing a significant setback, the prospect for healthy global economic growth appears extremely dim.  The GDP growth rates for the United States and the Eurozone have been anemic as they’ve considerably lagged growth rates in emerging markets.  Additionally, U.S. inflation has consistently been recorded beneath the Fed’s inflation target of 2% since the financial crisis began.  Additionally, whatever inflation the economy has registered in the last 6+ years has largely been due to “cost-push” inflation where prices rose as a side-effect of increased taxes and a more burdensome regulatory environment.  This is in direct contrast to the healthy “demand-pull” type of inflation the fed is desperately hoping to achieve where prices rise naturally due to increased economic activity.

The next several years is likely to shed a bright light on the failure of central banks as well as sovereign governments in regards to their abilities to stimulate and manage the global economy and implement effective monetary policy.  The perceived omnipotence of governments and central banks in regards to economics and monetary policy is long overdue to be forcefully challenged, and rightfully so.  We at GFC will do our best to help our readers navigate the volatility which we fully expecting to encompass the global investment landscape.

The global interest rate lift-off has begun!

GFC has been monitoring the price action in global bond markets closely over the past few months, and the recent price action appears to be portending a dramatic rise in interest rates that should gain momentum in the second half of this year.  As many other prominent economists have pointed out, the global bond (debt) bubble is shaping up to be the mother of all bubbles.  Years of artificial manipulation from central banks has led to the lowest interest rate environment anyone alive on planet earth has ever experienced.  Conversely, the central governments which have mostly constituted Western civilization for the last 250+ years are about to drown in the sea of debt they have accumulated.

One of the defining characteristics of the systemic risk that is now readily apparent in the U.S. bond market is the shockingly low level of liquidity.  Dealer inventory for fix-income markets has shrunk since the financial crisis while mutual fund assets, ETFs, and other financial derivative products related to fixed income have grown dramatically in size and scale.  The attached chart from Citi depicts the precarious situation developing for anyone thinking about trading a substantial amount of bonds.

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These liquidity conditions are sure to usher in severe volatility as it is unlikely that dealers will be able to maintain tight price spreads when everyone rushes for the exits all at once.  Eurozone bond yields have experienced dramatic moves so far this year.   Most noticeable are the cracks appearing in bunds, which are the German equivalent of U.S. Treasury bonds.  The interest rate on the 30-year German bund bottomed on April 17th when it yielded just 40 basis points.  However, earlier this month on June 10th it was trading at 1.629%! -A move of over 120 basis points in less than two months! Likewise, the rate on the 10-year German bund traded down just below 5 basis points in April.  It’s incredible that anyone would lend the German government money for 10 years and only required five one hundredths of a percent in return.  The default risk should alone should be higher than 5 bps,  but what bond traders are essentially saying is that the inflation risk in Europe has gone negative and they are staring the prospect of deflation squarely in the face.

During this time in April when global bond yields were near their lows, legendary investor Bill Gross, who holds the distinctive Wall Street title of being the “Bond King” called German bunds “the short of a lifetime.”  So far he has been 100% correct, and the 10-year German bond rallied over 100 basis points from it’s low as bond prices fell.  We at GFC believe that this past April was just the first of many opportunities to go short German bonds like Bill Gross did.  This is likely the first move in a new secular trend that will likely last many years into the future as government finances in Europe and United States begin to unravel as creditors realize that have been playing a fools game with short-sighted and fiscally irresponsible politicians.

Looking domestically to interest rates on the 30-year Treasury bond, we can see that since late January 30th rates for U.S. government debt have had a substantial move upwards.  Rates bottomed at 2.22% and recently made a high at 3.23%.  From the chart below you can see that during this move, prices traced out a 5-wave Elliott Wave impulse pattern which implies that the trend has changed direction. It appears as though the 5-wave impulse pattern is complete and we should now expect some type of an ABC correction to retrace this signature move.  The target range for the correction to end is highlighted in the green box in the chart below.  After this forecasted correction is over, it will most likely represent an excellent time to short bonds once again, with an even more dramatic rise in interest rates likely to follow later this year and into 2016.

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The low which was made earlier on January 30th,was likely the end of the a 34-year secular trend of declining interest rates in the United States dating back to 1981.  We at GFC cannot underscore enough how important the significance of this potential trend change is.  In layman’s terms, it means that the trend has changed from a 34 year environment where it had become easier and easier for the U.S. government to borrow money (which led to unmanageable levels of accumulated debt) to now an environment where it is going to be harder and harder for the U.S. government to borrow money as the cost of borrowing is set up to rise exponentially. From now on, the government of the United States is going to have a tougher and tougher time paying its bills.  If you are in the market for a mortgage, lock in a low interest rate now while you still can!  General expectations going forward should include widening budget deficits, an increased emphasis on tax collection, and extreme political upheaval.  The global interest rate lift-off has begun!

Market forecast update

In this update GFC would like to go back and remind our readers of some forecasts made over a month ago in GFC’s April 2nd article “Positioning for (Intermediate-Term) Dollar Weakness” and provide an update to how some of those forecasts have panned out.   Market dynamics are always fluctuating and we would like to update our readers on what market moves they should expect next.

The first chart shown below is when we advised our readers that a top in the dollar had likely occurred and that they should expect to see a weakening U.S. dollar index in the weeks ahead.

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Below is what unfolded after GFC made this market call….

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As shown in the above chart, shortly after this GFC forecast the dollar to weaken,  it finished retraced slightly higher and then dramatically sold off and prices immediately sunk to our cited target range.  In the near term we expect the dollar to bounce from this support level, but depending how volume characteristics evolve over the coming trading days, the dollar may have further to fall.  This was a minimum target objective that has been achieved.  If any compelling market opportunities develop regarding the dollar we will update you.

The next chart we would like to update is our forecast for oil.   Last Month GFC predicted oil to rally as believed it has formed an intermediate term bottom and was likely to rally as the dollar weaken.  After its initial bounce off the bottom, oil completed a 50% retracement which is where we predicted oil to rally to over $58 as seen in chart from April 2nd below.

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Again, this is what occurred in Oil after GFC predicted it to surge…

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Furthermore, it worth highlighting that while it was rallying, Oil formed a very distinct support trend-line which experienced multiple touched.  Zooming in on a 4HR chart highlight this support line which was broken yesterday.  We expect oil to substantially pull back to at the last the $56 area and possibly much lower over the intermediate term.

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Our forecast for a bull rally in gold has not materialized thus far.  We are still anticipating there to be a high probability that gold will attempt a rally towards the $1,300 level.  It should be noted that gold hasn’t broken down out of its trading range either, which implies that it has been build cause to rally soon.  We will keep monitoring these market developments as they occur and do our best to keep our readers posted.